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Hedge funds and the positive idiosyncratic volatility effect

Author

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  • Turan G. Bali
  • Florian Weigert

Abstract

While it is established that idiosyncratic volatility is negatively priced in the cross-section of stock returns, the relation between idiosyncratic volatility and hedge fund returns is largely unexplored. We document that hedge funds with high idiosyncratic volatility earn higher future risk-adjusted returns of 6 percent p.a. than hedge funds with low idiosyncratic volatility. The outperformance arises because hedge funds trade high idiosyncratic volatility stocks wisely. They pick high volatility stocks when they are underpriced and short-sell high volatility stocks when they are overpriced. Our results support the notion that hedge funds’ idiosyncratic volatility is a measure of managerial skill.

Suggested Citation

  • Turan G. Bali & Florian Weigert, 2024. "Hedge funds and the positive idiosyncratic volatility effect," Review of Finance, European Finance Association, vol. 28(5), pages 1611-1661.
    • Handle: RePEc:oup:revfin:v:28:y:2024:i:5:p:1611-1661.
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    File URL: http://hdl.handle.net/10.1093/rof/rfae022
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    More about this item

    Keywords

    hedge funds; idiosyncratic volatility puzzle; equity portfolio holdings; short-selling; managerial incentives; investment performance;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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